Impairment testing: Effectively using the qualitative assessment

Evaluate all options to reduce costs and complexity.

Historically, many organizations have conducted goodwill and
indefinite-lived intangible asset impairment testing by collaborating
with valuation professionals and other advisers to measure fair value
of their reporting units and indefinite-lived intangible assets. With
recent changes to impairment testing and, specifically, the
introduction of optional qualitative assessments to potentially avoid
the quantitative tests, entities are seeking insights about how to
navigate their way through the impairment-testing process and, where
practical, reduce associated costs and complexity.

While the qualitative assessment will reduce the cost and complexity
of impairment testing for many entities, there will be situations in
which quantitative tests will continue to be the most effective way to
perform impairment tests. The purpose of this article is to explore
the qualitative assessment option and present factors that entities
should consider before deciding to perform a qualitative assessment.
An awareness of these topics will help entities evaluate whether a
qualitative assessment is the most effective available solution for
impairment testing.

EVALUATING THE APPLICATION OF ASU 2011-08 AND ASU 2012-02

FASB’s Accounting Standards Update (ASU) No. 2011-08,
Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for
Impairment, issued in September 2011, permits the use of a
qualitative assessment in testing goodwill for impairment. ASU No.
2012-02, Intangibles—Goodwill and Other (Topic 350): Testing
Indefinite-Lived Intangible Assets for Impairment, issued in
July 2012, permits the use of a qualitative assessment in testing
indefinite-lived intangible assets for impairment.

ASUs 2011-08 and 2012-02 did not change the quantitative tests for
goodwill or indefinite-lived intangible asset impairment testing,
respectively. For instance, ASU 2011-08 states that if, based on a
qualitative assessment, an entity determines that it is more likely
than not that the fair value of a reporting unit is less than its
carrying amount, the entity is required to perform Step 1 of the
quantitative test. If, based on a qualitative assessment, an entity
can support a conclusion that it is not more likely than not that the
fair value is less than the carrying amount, then Step 1 is not
required.

ASUs 2011-08 and 2012-02 provide entities the option to
qualitatively assess events and circumstances relevant to the fair
value of a reporting unit or indefinite-lived intangible asset to
determine whether a quantitative test is required. The amount of
analysis and documentation required will depend on specific facts and circumstances.

The intent of the ASUs was to reduce the burden on entities when it
is more likely than not that an impairment would not be identified
through the quantitative tests. In evaluating whether a qualitative
assessment might be an efficient approach to impairment testing,
entities could consider several factors, including:

Costs of process implementation for qualitative assessments;

Initial review of fair value at the time of a transaction;

Possibility of an unclear outcome from a qualitative assessment;

Moving in and out of the qualitative assessment from period to
period;

Ability to repurpose other valuations; and

Uncertainty around in-process research and development (IPR&D) assets.

COSTS OF PROCESS IMPLEMENTATION FOR QUALITATIVE ASSESSMENTS

When conducting a qualitative assessment, an entity may consider the
need to institute a process with appropriate internal controls. The
extent of effort that may be required to implement the process and
related controls varies depending on the entity’s circumstances with
its reporting units and other indefinite-lived intangible assets. The
ASUs provide examples of qualitative factors for consideration but do
not provide explicit guidance regarding how these factors should be
evaluated. The qualitative assessment process could, depending on the
circumstances, introduce more variation in perspectives among
management, valuation and auditing professionals, and regulators.
Where opinions face a higher probability of varying, more discussion
and documentation may be required. In some cases, it may be more
effective to continue with existing quantitative tests when extensive
efforts may be necessary to perform and document the qualitative assessment.

INITIAL REVIEW OF FAIR VALUE AT THE TIME OF A TRANSACTION

One of the most effective ways of monitoring the qualitative factors
is to document the mindset in place at the business combination or
asset acquisition date (collectively referred to as a transaction
date) and identify the critical drivers of fair value for the
reporting units or indefinite-lived intangible assets. This becomes
especially important for an entity that intends to use the qualitative
assessment at the impairment testing date immediately following the
transaction date because, assuming the transaction price was at fair
value, the cushion, which is the excess of the fair value over the
carrying amount at the date of the last valuation, would be zero.

Analysis of fair value drivers and identification of events and
circumstances at the time of the transaction and related subsequent
changes in those drivers would serve as a highly relevant foundation
for subsequent qualitative assessments.

POSSIBILITY OF AN UNCLEAR OUTCOME FROM A QUALITATIVE ASSESSMENT

Too close to call. If a reporting unit’s or
indefinite-lived intangible asset’s fair value has recently been close
to its carrying amount, then the lack of cushion may create
alternative views about the results of the qualitative assessment. An
unfavorable economic environment at the testing date may exacerbate
this dynamic.

Also, as the amount of time between the last fair value measurement
and the current testing date increases, the more difficult it may be
to make a conclusion based solely on a qualitative assessment of
relevant events and circumstances. In these situations the evidence
presented in the qualitative assessment may not be sufficient to avoid
the need to use a quantitative test. The uncertainty or lack of
clarity about the qualitative assessment may make it more effective to
begin with the quantitative test in these circumstances.

Single-asset volatility. In certain instances, the
efforts involved in tracking individual factors may be excessive and
may not be practical given the dynamic nature of businesses. A more
holistic consideration of the business could be more effective because
factors evolve quickly in a particular business environment.

For example, consider a hypothetical company that identified certain
key fair value diagnostics—qualitative factors—at the transaction date
linked to the customer base as critical to the impairment assessment
of goodwill. Subsequent to the acquisition date, the company’s
membership-based model evolved to a free-usage model funded instead by
advertising revenues. Here, one might say that the business’s
intangible asset mix has changed. The qualitative factors that an
entity may have selected at the time of the acquisition, which are
centered primarily on the membership-based intangible asset, may
suggest negative business momentum or that recorded goodwill is in
peril.

ASU 2011-08 allows for a change in factors and also allows for
consideration of positive and mitigating factors. However, this
example highlights the fact that goodwill tends to reflect the
performance of a portfolio of assets deployed by the business for
economic benefit rather than—in this case—narrowing in on one asset
type. Quantitative goodwill impairment testing at the reporting unit
level can accommodate shifts in the composition of the business’s
tangible and intangible assets whereas a focus on a single asset
cannot. This demonstrates a situation where the quantitative test can
be less volatile than the qualitative assessment.

MOVING IN AND OUT OF THE QUALITATIVE ASSESSMENT FROM PERIOD TO PERIOD

Entities may wish to make a preliminary assessment each period to
determine whether to begin with the qualitative assessment or to go
directly to the quantitative test. Entities have an unconditional
option each period to perform the qualitative assessment and may also
alter their use of the qualitative assessment year over year. In the
case of the latter, additional resources may be required if an entity
decides to continue using the qualitative assessment but wishes to
modify the factors considered relevant in the assessment. Although
costs may be reduced in years when the qualitative assessment is
sufficient to support a “no impairment” conclusion, comparatively
higher costs may be incurred in years when an entity determines that
it must revert to a quantitative test for a particular reporting unit
or indefinite-lived intangible asset.

Several instances can be shown where quantitative tests have been
performed in consecutive periods and the second test leveraged off
insights gained from the first. On occasion, these efficiencies have
allowed for the cost of the second test to be less than the first. If
a qualitative assessment is performed between two quantitative tests,
the interruption of year-over-year quantitative tests may result in a
loss of cost efficiencies and relatively higher costs for the most
recent quantitative test.

ABILITY TO REPURPOSE OTHER VALUATIONS

Occasionally, implementation of additional processes to perform a
qualitative assessment may be unnecessary. For example, there may be
times when inputs and other information from valuations performed for
purposes other than impairment testing are readily available for use
in a quantitative test. For example, some companies require an equity
valuation for stock compensation purposes when applying ASC Topic 718,
Compensation—Stock Compensation. Other examples include
valuations conducted for purposes of supporting an entity’s compliance
with loan covenants, or when private-equity investors require a
periodic valuation of the entity’s equity for its mark-to-market
purposes.

If the entity performs a valuation anyway, it may be more efficient
to make adjustments to that valuation to comply with Step 1 of the
goodwill impairment testing model rather than investing resources to
implement processes and controls to perform the qualitative
assessment. Potential differences between a valuation conducted for
the aforementioned purposes and for purposes of ASC Topic 350,
Intangibles—Goodwill and Other, may result from:

There may be practical challenges to leveraging such valuations,
but in many cases the obstacles can be overcome. If so, the output of
these valuations may make it easier to move directly to Step 1 and
support a position about the absence of impairment.

UNCERTAINTY AROUND IPR&D ASSETS

The principles that apply to the intangible assets covered by ASU
2012-02 are largely consistent with those applicable to goodwill.
However, certain indefinite-lived intangible assets, such as IPR&D
assets, warrant special consideration. According to ASC Topic 805,
Business Combinations, IPR&D assets acquired in a
business combination are measured at fair value at the acquisition
date and recorded as indefinite-lived intangible assets until the
completion or abandonment of the associated research and development
efforts. As a consequence, eventually the life of IPR&D assets
will become known, unlike some other indefinite-lived intangible
assets and goodwill that remain indefinite-lived for extended (i.e.,
indefinite) periods of time.

Indefinite-lived intangible assets that become finite-lived assets
are tested for impairment using the indefinite-lived intangible asset
fair value model one last time at that date. Subsequently, they are
subjected to impairment testing under ASC Topic 360, Property,
Plant, and Equipment (as a finite-lived, depreciable, or
amortizable asset).

In its deliberations leading to the issuance of ASU 2012-02, FASB
considered whether to retain the current quantitative impairment
testing guidance for IPR&D assets and other indefinite-lived
assets whose fair value involves significant uncertainties. FASB
acknowledged the difficulty in conducting a qualitative assessment for
IPR&D assets but opted not to exclude it from the scope of the new
ASU because the assessment is optional and there may be situations
where its use is appropriate.

From a practical standpoint, the nature of IPR&D assets may make
use of the qualitative assessment less effective in many situations.
The costs of implementing a process and related controls, as well as
the uncertainty of the result, may outweigh the benefits derived from
avoiding a quantitative test. The situation becomes more pronounced if
processes or qualitative factors differ across discrete projects.
Isolating key drivers and events and circumstances underlying an
IPR&D project may be more difficult than assessing it
holistically. However, entities may use the qualitative assessment
with greater frequency for situations in which an IPR&D project is
nearing successful completion or is completed successfully and tested
one last time as an indefinite-lived intangible asset.

CONCLUSION

The qualitative assessment framework for impairment testing recently
introduced by the ASUs may reduce complexity and costs for many
entities. In other cases the qualitative assessment may not prove
cost-beneficial. Professionals may want to develop a screen to help
more quickly determine whether the qualitative assessment for
impairment testing is likely to be the most efficient strategy.

Careful consideration should be given to the facts and circumstances
for specific reporting units and indefinite-lived intangible assets to
determine the most effective and efficient path forward. Some entities
may be better served continuing with the quantitative test to assess
impairment of goodwill for some of their reporting units or certain
indefinite-lived intangible assets.

New Chapter in the WorksThe AICPA’s Financial Reporting Executive Committee (FinREC) has
issued a working draft of a new chapter of the AICPA Accounting and
Valuation Guide Testing Goodwill for Impairment (the Guide).
The new chapter - chapter 2, Qualitative Assessment -
discusses and illustrates how to perform the optional qualitative
assessment to determine whether it is necessary to perform the
two-step goodwill impairment test described in FASB ASC 350-20. This
new chapter was developed in response to feedback received on the
working draft the Guide which was released in November of 2011.

The working draft of the new chapter is available at aicpa.org.
Interested parties are encouraged to submit their informal feedback on
the new chapter by December 31, 2012.

EXECUTIVE SUMMARY

The addition of a qualitative assessment for
impairment testing under recent Accounting Standards Updates may
reduce complexity and costs for many companies.

The determination as to whether a qualitative assessment will
reduce costs and complexity may not be straightforward, and
certain factors should be considered when determining whether it is
more cost-effective to perform the qualitative assessment or to
proceed directly to the quantitative impairment tests for goodwill or
indefinite-lived intangible assets.

Factors to consider include the costs to implement
the qualitative assessment process, unclear outcomes of the
qualitative assessment, moving in and out of the qualitative
assessment from period to period, the ability to repurpose other
valuations, and uncertainty around IPR&D assets.

Valuation professionals can help entities move
quickly to determine if the qualitative assessment is
cost-efficient in their situation. Some entities will end up
continuing to use a quantitative test to assess goodwill impairment.

BJ Orzechowski (bjorzechowski@kpmg.com) is a valuation services partner at KPMG LLP in Philadelphia.
Peter Lyster (plyster@kpmg.com) is a managing director in KPMG’s Department of Professional
Practice in New York City.

To comment on this article or to suggest an idea for another
article, contact Neil Amato, senior editor, at namato@aicpa.org or 919-402-2187.

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